The 21st Century Term Sheet - Part 1

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

Periodically, we come up with ideas for improvements in the
"green goods" business, meaning transactional
corporate finance with an accent, in our case, on venture
capital and buyouts. By way of ancient history see the
following links,[2]
for suggested improvements in the areas of: predatory class action
litigation; equity flavored executive compensation which better aligns
the interest of the executive and the shareholders; and re-opening the
IPO window for mid-cap venture-backed companies. If the truth
be told, several such suggested improvements have yet to gain the kind
of currency which we think they deserve. If at first,
however, you don't succeed - the
following innovation, accordingly (and hopefully) will catch on and, in
the process, cut away a lot of the frictional costs of negotiating
placements in the venture sector.

By way of background, a typical lecture from this source to a
seminar at, say, Cornell business school class stresses a fundamental
truth in corporate finance generally. Every transaction
consists of both price and terms. One of
the great negotiators on Wall Street was reputed to have made money by
repeating the mantra, "your deal, my
terms." What that meant was that he would allow the
seller or buyer to name the price if he was given the latitude to set
the terms.[3]

An idea has occurred to me which can, in my view, lend
significant clarity and transparency to negotiation of, say, the Series
A round.

Assume the following hypothetical: A promising
company is soliciting a Series A round from top decile venture
capitalists and the lead investment fund has agreed to a notional
pre-money valuation of, say, $50 million. The VCs then
propose a $20 million investment, the terms including an uncapped
participating preferred with a 12% coupon for 28.6% of the company,
reverse vesting on the founder's stock, a put back to the
company after four years; a milestone staged schedule for the $20
million commitment, based on the issuer's
projections. Issuer's counsel retorts with a 3x cap
on the participating preferred, an 8% cumulative dividend, no
milestones, weighted average anti-dilution protection. The
parties are able to agree on the governance procedures and pre-money
valuation; but the deal terms become extremely controversial as the
Samurai law firms duke it out over what is "fair"
and what is "market" vis-a-vis the
terms. The partner of the lead venture firm is constrained
because she is a junior member and will be embarrassed if she goes back
to the committee, which votes unanimously and is dominated by long time
VCs, with deal terms they view as naive ... a product
of her less than first rate negotiating skills. The founders and her
fellow board members, on the other hand, are confused by the swirling
rhetoric ... even after consulting the
Fish &
Richardson/VC Experts Series A deal terms survey. They are
unsure of what they are giving up in real economic terms ...
when, shazam the new term sheet model comes to the
rescue.

The suggestion made by this "expert" from
VC Experts, is that the deal terms discussion is getting the cart
before the horse. The 21st Century
term sheet can be much simplified ... a model of
clarity. The new paradigm has the following
characteristics.

First, the assumption is made that the $50 million pre-money
valuation is valid for purposes of a Series A, minority
investment. That number is posted on a White Board in the
conference room. Next, the parties agree that, if the entire
company were up for sale, standard economic modeling suggests a 30%
control premium. Accordingly, the discussion segues to a
stipulation that, were the company to be sold as a unit to either a
financial or a strategic buyer, the gross proceeds to the shareholders
would be $65 million. The next, and semi-final, act in the
drama is to agree on a hierarchy of likely, although of course not
certain, valuations for a subsequent trade sale if $20 million were
infused and the company managed without further equity financing for,
say, the succeeding four years. This is one year short of
today's typical VC outside target for an exit but the outer
limit the company responsibly thinks its projections can have
indicative value; a shorter period of three years, for example, is, of
course, acceptable if the market and the business prospects of the
company so indicate.

The parties agree that, regardless of the formal control
mechanisms, the VCs will be able to put the company in play at the end
of the stated period, whether or not the founders continue to believe
that prosperity is just around the corner. In fact, one
compelling component of what might be called the 'drop
dead' date calculation is how long the VCs think they have
before they must show results to their LPs so that they can raise the
next fund ... and continue to live in Greenwich, Woodside or
Chestnut Hill, in the style to which they have become
accustomed.

The White Board then shows, a column with pretty simple
numbers on it, stopping at a number which is at the outer limits of
plausibility viz:

In the penultimate phase, it is up to the VCs to fill in, at
each of these exit valuations, what do we (the VCs) get and what do you
(the existing shareholders) get? The red carpet is laid down
and the invitation extended to the VCs and their advisers: Fill in
these numbers. Assume a trade sale, all cash. How
do the proceeds get split up? How much for you? How
much for us? Have quants, the fresh faced MBAs in your
employ, run your calculations based on what, given the risk/reward
calculus, you think you need at the end of the day. Give us
an honest count, as we know you will, and focus on the bottom line ...
net, net, net, what do the VCs get for hanging in there
until we, the current owners, are able to put some more points on the
board, operating lean and mean.

The founders, the angels ... the existing
shareholders ... should then be able to do their own
risk/reward calculation, using their best guesstimates. If it
later turns out they are wrong, maybe they should have sold the company
... or scraped by on fumes until the picture
improved. That's the luck of the draw. An economy built around
entrepreneurship is bottomed on this kind of risk,
and the calculations which accompany it.

But, the owners of the company should not need anybody to
translate, and often imperfectly, from a foreign language ... i.e.,
deal terms. They should have clarity vis-a-vis the
result which they will enjoy, depending on what they are able to
achieve as managers before the company is sold. Once the
parties are in agreement ... and our suggestion is they will
come rapidly to agreement given the simplicity of the model (or
disagreement, for that matter) ... then it is up to the
lawyers to fill in the deal terms which will achieve the
result. If that proves to be too hard for a given law firm,
then the idea is to get another one. The deal terms should
laser in on the results desired. The VCs will want downside
protection and they will get it at, say, $70 million; since they put up
the new money, they will get most of the available money off the table
through their liquidation preference. From there on up, the
deal terms will be calibrated ... perhaps using examples
(which we much admire) to make sure everybody understands what the
outcome is destined to be. There are always surprises in this
business; but the model term sheet we are suggesting minimizes the
surprises, in our view, and more importantly, significantly enhances
clarity and transparency.

The last act in the drama is for the principals with their
money at risk (the VCs and the issuer) to tell the lawyers what to do
...to take charge of the process, in other words. The instructions are:
draft a term sheet which reaches the economic
results upon which the parties have agreed. Obviously, there
will be down side protection for the investors in the case of
disaster. One conventional instrument which would accomplish
that goal is a note secured by a protected lien on the
company's intellectual property. And, a cumulative
dividend will make it easier for the VCs to add to their up side, with
due regard for the time value of money, by adjusting the conversion
formula periodically. But the bottom line is, "You
lawyers! Stop showing each other how tough you are. Sit down and give
us language which produces the desired
results. Cover the contingencies ... earn outs,
escrows, break up fees, etc....in your language, and get us
to the finish line."

[1]
Readers are invited to volunteer as a contributing editor. E-mail joe@vcexperts.com,
if you would like to work with me on a favorite project and we can
conjure up the appropriate analysis so that the end result will have
instructive value.

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